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Monetary Policy Impacts on Share Prices

Central banks all attempt to modify the cost of money or interest rates, the supply of money, and the availability of money. This is known as their monetary policy. All things being equal the lower the cost of money and the greater its supply, the greater the economic activity and vice versa.

Typically a central bank modifies the interest rate through various conventional means. This includes setting short term interest rates, buying and selling short term government bonds from / to financial institutions in the open market.

Since the global financial crisis in 2007/2008 – which had a severe impact on the housing, employment, and general economies of developed markets – central banks have been struggling to revive their economies. In the years and even decades up to the crash, lowering the cost of debt provided a quick fix to an economy that loved debt. But post the bubble it’s been a struggle to resuscitate economies even as central banks have brought interest rates down to record low levels of close to 0%.

Because central banks now don’t have much room to manoeuvre on the interest rate front, they have embarked, over the last 4 years, on various methods of quantitative easing (QE). This is an attempt to stimulate the real economy when the more conventional means are not as effective. In the latest announcement from the US Federal Reserve, it will involve buying up to $40 billion per month of agency mortgage backed securities.

The Federal Reserve did this after the 2007/2008 financial crisis, trying to provide a backstop to the financial system by printing and buying up $600 billion in mortgage backed securities. Then in November 2010 the US Federal Reserve announced a second round of quantitative easing (QE2) through a process of buying $600 billion of treasury securities.

The chart below reflects the US Federal Reserve Balance sheet expansion due to printing from around $800 billion to almost $3 trillion.

US Fed Balance Sheet

Source: US Federal Reserve website

Now the QE3 announced last week sees a reversion to the government buying private mortgages held by the government sponsored agencies. Because the US Federal Reserve owns a lot of other debt which matures over time, it will also reinvest all proceeds its receives. The sum of these actions is a monthly purchase of around $85 billion and according to the Fed Reserve, “......should put downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative.”

The Fed is linking the fresh injection of money into the banking system with the labour market and will only stop once there is a substantial improvement in the labour market, saying “To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthen.”

So far it’s difficult to see what the very accommodative monetary policy has done for the real economy, but one apparent consequence has been an on-going upward rise in share prices following the 2008 sell off. Given the stated intention of officials to continue for as long as it takes, this should provide an on-going underpin to the price of risk assets.